Shareholders' equity is often thought of as another piece of confusing stock market terminology. In reality, shareholder equity is a key concept in corporate accounting and an important measure of company valuation. Despite its lofty purpose, the calculation of shareholder equity is simple. Shareholders' equity is a company's total assets, minus its total liabilities.

So what does a large amount of shareholder equity signify about the financial health of a company? Firstly, it indicates the company is on solid financial ground. Shareholder equity represents owned funds that can be used to pay dividends to investors or to stimulate additional growth. These goals can also be funded by taking on debt, such as bank loans, though borrowing money is inherently riskier. A high level of shareholder equity means growth or dividends can be funded without the risk of bankruptcy in the event of a business downturn. For companies that primarily use debt financing, a dip in sales can mean big trouble since payments on liabilities must be made regardless of revenue fluctuation.

However, not all debt is bad debt, and a high level of shareholder equity can also mean a company is not optimally leveraged. Companies use debt, or leverage, as a means to expand operations at a rate that is not possible using shareholder equity alone. Especially for businesses in their early years, using debt to stimulate rapid growth can be a lucrative business strategy. An expanded business can mean greater profits for the business owners and their shareholders. So while a large amount of shareholder equity is a sign of financial strength, an unusually high ratio of equity to debt can signify a company is missing out on the potential growth opportunities offered by leverage financing.

  1. How do you calculate shareholders' equity?

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  2. What does negative shareholder equity on a balance sheet mean?

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  3. What are the components of shareholder equity?

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  4. What is the most widely used gearing ratio?

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  5. How do companies use the equity multiplier to determine a financing strategy?

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  6. What role do shareholders play in a capital budget?

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